An essential allocation for a new market regime

Investors today face a much more difficult return environment than they’ve experienced in recent decades, and diversifying beyond stocks and bonds is likely to become increasingly important. Compared to the last 10 years, we forecast slower real growth, stubbornly high inflation and greater volatility over the next decade. Various factors drive this view, including labor scarcity, commodity underinvestment, increased geopolitical uncertainty, and a move away from globalization (to what can be termed friend-shoring or trade- partner selectivity). The result will likely be lower profit margins and sub-par returns for the broad equity market. We believe bonds are likely to be more volatile as this happens, making them less effective in counteracting the volatility of stocks.

In contrast, we believe real assets—in particular, natural resource equities and infrastructure—are well positioned in a higher inflationary environment for more substantial annualized returns over the next 10 years, driven by higher levels of profitability and a more supportive valuation environment. Commodities, we believe, will see a meaningful improvement in returns as we move from persistent oversupply to a period of prolonged undersupply. After years of under-investment, commodity prices are likely to be driven by higher production costs and operating expenses, a higher cost of capital, and higher risk premia.

Keep in mind that real assets are coming off their worst decade on record relative to the broad equity market, potentially setting the stage for significant real assets outperformance in the years ahead (Exhibit 1).

EXHIBIT 1

Annualized returns and ratio of real assets blend vs global equities

June 1991–March 2023

At March 31, 2023. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream and Cohen & Steers.
Past performance is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers. The real assets blend is not representative of an actual portfolio and is for illustrative purposes only. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend will begin. See end notes for index associations, definitions and additional disclosures.

Sign up to get our insights delivered to your inbox

Subscribe

DC plan lineups generally lack adequate diversifiers

Defined contribution plan menus have historically been short on portfolio diversifiers, consisting largely of core equity and fixed income strategies (Exhibit 2). That’s especially true of target-date funds, the vehicle of choice for many retirement savers.

The result is that the traditional 60/40 equity/bond allocations that form the foundation of most target-date funds have come under significant scrutiny. In 2022, The Wall Street Journal questioned whether target-date funds are appropriate for most investors, while Barron’s called target-date fund returns “mediocre.”(1)

One key challenge is the lack of diversification within target-date products. The goal of portfolio diversification is to own asset classes that tend to experience their above- and below-average returns in different economic and market environments—when one asset zigs, the expectation is that another will zag.

EXHIBIT 2

The need for diversifiers has perhaps never been greater

Average asset allocations in DC plans

At December 31, 2022. Source: Callan Associates and FUSE Research.
Based on asset allocations of over 100 large defined contribution plans representing approximately $350 billion in assets, tracked in the Callan DC Index™. Diversifiers include Alternatives/Other, Real Estate, Real Return/TIPS and Specialty Equity. Stock funds include Emerging Markets Equity, Global Equity, Non-U.S. Equity, U.S. Large Cap and U.S. Small Cap. Bond funds include High Yield, Money Market, Non-U.S./Global Bond, U.S. Bond and Stable Value. See end notes for additional disclosures.
(1) “The Stock Market’s Drop Is Hitting Many 401(k)s Harder This Time,” The Wall Street Journal, May 23, 2022; “Target-Date Funds Are Popular. But Mediocre Returns and Other Risks Warrant a Closer Look,” Barron’s, June 3, 2022.

Diversifiers historically have represented only a small fraction of DC plan assets

Target-date funds typically have low and incomplete real asset allocations, consisting primarily of inflation-protected U.S. Treasuries and real estate securities (Exhibit 3).

EXHIBIT 3

Target date funds have low dedicated allocations to real assets

At March 31, 2023. Source: Morningstar Direct, Cohen & Steers analysis.
Reflects the average allocation to dedicated real asset strategies of the 20 largest Target Date Collective Investment Trust Series. See end notes for additional disclosures.

In recent years (2022’s price declines notwithstanding), an increasing number of investors have looked to solve this problem by carving out a portion of their portfolio for real assets. Today, the universe of listed real assets has grown beyond real estate to encompass other asset classes, including multi- strategy real assets portfolios (Exhibit 4).

Institutional managers—including sovereign wealth funds, defined benefit (DB) plans, and endowments and foundations—frequently allocate as much as 20% to diversifiers such as real assets. By contrast, defined contribution plan weightings in real assets investments are well below institutional allocations, averaging around 1%.

EXHIBIT 4

Investments in real assets have risen sharply since 2007

Global assets under management in listed real assets strategies ($ billions)

At December 31, 2022. Source: eVestment Alliance. See end notes for additional disclosures.

A good fit for defined contribution plans

Institutional investors have chosen to strategically allocate to real assets partly because of their diversifying effects. In periods of rising and unexpected inflation, for instance, real assets historically have significantly outperformed stocks and bonds (Exhibit 5). Real assets’ ability to counter inflation offers potential benefits to portfolios in the short term, as prices climb, and in the longer term, should inflation rates continue to surprise to the upside.

EXHIBIT 5

Real assets have historically outperformed in inflationary environments

Average annual real returns in periods of rising and unexpected inflation (%), June 1991–March 2023

At March 31, 2023. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream, Cohen & Steers.
Past performance is no guarantee of future results. Inflation measured as the year-over-year change in the Consumer Price Index for all urban consumers, published by the U.S. Bureau of Labor Statistics. Rising inflation measured as a positive year-over-year increase in the 12-month inflation rate. Unexpected inflation measured as a positive difference between the year-over-year realized inflation rate and lagged 1-year-ahead expected inflation, as measured by the University of Michigan survey of 1-year-ahead inflation expectations. The real assets blend is not representative of an actual portfolio and is for illustrative purposes only. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. See end notes for index associations, definitions and additional disclosures.

Real assets can help to counter the ravages of inflation.

Real assets may be appropriate for an evergreen retirement plan asset allocation as their distinct economic sensitivities further differentiate them from traditional risk assets such as stocks and bonds.

The historical benefits of real assets’ differentiated economic drivers can be seen in their “beta,” i.e., their sensitivity to the broad global equity market (Exhibit 6). A beta of less than one indicates that the asset class (over the analyzed timeframe) exhibits less volatility than the broad equity market. The low market beta of real assets suggests significant diversification potential, which may help to reduce portfolio volatility—and, we believe, improve risk- adjusted returns.

EXHIBIT 6

Low market beta suggests significant diversification potential

Beta to global equities, June 1991–March 2023

At March 31, 2023. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream, Cohen & Steers.
Past performance is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers. The real assets blend is not representative of an actual portfolio and is for illustrative purposes only. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend will begin. Beta measures an investment’s relative volatility compared to a standard market index. A market index will always be equal to 1.00. An investment with a higher/lower beta, more/less than 1.00, is more/less volatile than the market index. See end notes for index associations, definitions and additional disclosures.

A real assets blend can be an important portfolio diversifying element, on top of the attractive inflation sensitivity.

Historically strong returns with less volatility

Listed real assets have historically generated strong returns over full market cycles, with all but commodities delivering performance in line with or better than global stocks over the past 30+ years (Exhibit 7).

The long-term average for commodities was depressed by a decade-long bear market in commodities from 2008 to 2018, driven by China’s orchestrated downshift in demand, significant technological advances in oil and gas drilling, and a decade of low interest rates and cheap access to capital. These unusual factors led to a prolonged commodity oversupply cycle. Commodities have since experienced substantial improvements in supply/demand fundamentals, including strong global post-Covid reopening demand, tight inventories (exacerbated by the Russia-Ukraine war) and a more supportive macroeconomic backdrop, providing potential catalysts for a sustained multi- year recovery.

There are significant potential benefits of combining an array of real assets within a single portfolio. Individual real assets categories can be quite volatile. But across full economic and market cycles, the desynchronized payoffs of the different categories mean that in a diversified framework, a strategic allocation to listed real assets may offer utility to investors, historically delivering competitive returns with significantly less volatility than global stocks.

EXHIBIT 7

Historically a better risk profile from real assets

Historical risk and return comparison, June 1991–March 2023

At March 31, 2023. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream, Cohen & Steers.
Past performance is no guarantee of future results. Return reflects compound annualized return. Risk reflects annualized standard deviation of monthly returns. Standard deviation, also known as historical volatility, measures the dispersion of a set of data from its mean and is used by investors to gauge the amount of expected volatility. Sharpe ratio is a measure of risk-adjusted return, calculated by subtracting the risk-free rate from a return and dividing that result by the standard deviation. The higher the Sharpe ratio, the higher the risk-adjusted return. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. See end notes for index associations, definitions and additional disclosures.

A blended solution to potentially enhance returns

Implementing real assets in DC plans

Given their attractive investment attributes, we believe adding listed real assets to retirement plan investment lineups can be an effective way for fiduciaries to help plan participants diversify their portfolios and improve potential outcomes. During the disinflationary 2011–2020 period, there generally was no penalty for forgoing allocating to real assets. However, the return of inflation risk heightens the importance of a dedicated real assets allocation. This was strikingly evident in 2022 when fixed income and broad equities simultaneously came under pressure.

Even including the great disinflation of the previous decade, historical analysis shows that including a blend of real assets in an illustrative portfolio of stocks and bonds offers the potential to reduce volatility, improve risk-adjusted returns and help defend against inflation. (Exhibit 8). We attribute these results to the distinct return drivers of the underlying assets and their individual sensitivities to the business cycle, which provide potential diversification benefits.

EXHIBIT 8

Real assets offer the potential for improved risk-adjusted returns without sacrificing growth

Adding real assets to a stock/bond portfolio, June 1991–March 2023

At March 31, 2023. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream, Cohen & Steers.
Past performance is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. Return reflects compound annualized return. Volatility (risk) reflects annualized standard deviation of monthly returns. Sharpe ratio is a measure of risk-adjusted return, calculated by subtracting the risk-free rate from a return and dividing that result by the standard deviation. The higher the Sharpe ratio, the higher the risk-adjusted return. Inflation beta was determined by calculating the multivariate regression beta of 1-year real returns to the difference between the year-over-year realized inflation rate and lagged 1-year ahead expected inflation, including the level of the lagged expected inflation rate. Inflation is measured using the Consumer Price Index (CPI) for all urban consumers, published by the United States Department of Labor’s Bureau of Labor Statistics. Expected inflation as measured reflects median inflation expectation from University of Michigan Survey of 1-Year Ahead Inflation Expectations. A real rate of return is the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend will begin. Stocks represented by MSCI World Index. Bonds represented by ICE BofA U.S. 7-10 Year Treasury Index. Real assets blend composed of 27.5% global real estate securities, 27.5% commodities, 15% natural resource equities, 15% global listed infrastructure, 10% short-duration fixed income and 5% gold. The real assets blend is not representative of an actual portfolio and is for illustrative purposes only. See end notes for index definitions and additional disclosures.

The potential diversification benefits of real assets are likely to be even greater going forward given the increasingly challenging return environment for stocks and bonds.

The active advantage

Cohen & Steers’ multi-strategy approach to real assets provides diversification at the asset level while also seeking to further enhance returns through bottom- up stock selection and a top-down asset allocation process. Each asset class in the portfolio is managed in-house by a dedicated investment team, providing separate opportunities to add value through over- and underweights relative to the respective benchmark. Because each underlying strategy has its own investment process, this spreads the impact of active management across the sleeves of the portfolio.

From the top down, instead of using a simple, equal-weighted blend of real assets, we take a strategic approach to portfolio design, setting a target allocation range for each asset class according to its investment characteristics. We then adjust these allocations dynamically based on our current market view, providing an additional lever for both risk management and the enhancement of return potential.

For the retirement plan participant, we believe this approach is superior to owning individual real assets funds, as it helps to reduce menu clutter while potentially providing stronger and more consistent results.

Conclusion

Even with the recent cooling in inflation, we believe, and history suggests, that real assets can provide long-term benefits to retirement allocations. In our view, a diversified multi-asset-class approach to real assets not only offers distinct advantages from an investment perspective but is also consistent with the objectives of plan sponsors and participants. To summarize:

• A diversified multi-asset-class strategy effectively addresses the three objectives of diversification, long-term return potential and inflation sensitivity.
• For the sponsor seeking to minimize menu clutter, a single real assets option can provide a streamlined solution that encourages sensible asset class diversification.
• For participants, access to real assets may help to increase confidence in their ability to achieve their financial goals at a time of uncertainty for stocks and bonds. In our view, portfolios that are actively managed may provide an important advantage in achieving sufficient growth potential.

We believe a multi-strategy real assets option can provide an efficient way to diversify and align portfolios for the investment challenges that lie ahead.

Appendix: What are real assets?

Real assets are the structures and raw materials that allow for a productive economy—the properties where you live, work and shop; the infrastructure assets that provide power and water or enable transportation and communication; and basic natural resources such as food and heating oil. These tangible assets typically come early in the supply chain and tend to be sensitive to changes in inflation—either driving inflation themselves (as higher energy prices do) or given cash flows and asset values that may have direct or indirect links to inflation.